Pension fund investment strategies are facing a rocky ride as the US Federal Reserve continues to take steps towards ending quantitative easing by gradually tapering the amount of bonds it purchases.

Photo credit: Corbis

Fund managers and advisers are warning that schemes holding assets that have benefited from quantitative easing, such as investment-grade and high-yield bonds, could feel the effects of tapering.

While this heralds the start of the journey towards a more normalised macroeconomic environment, industry participants have warned that it is impossible to predict how markets will respond.

The introduction of tapering in the US is a key inflection point for Tapan Datta, head of global asset allocation at Aon Hewitt, who said: “Tapering is psychologically important because it marks an end to stimulus and a switch to tighter monetary policy.”

Datta added: “If the exact impact of this monetary expansion was clear, then it would be easier to predict the impact of removal of this liquidity. But there is no agreement on how the liquidity has affected both economies and markets.”

Although economists expect the Fed to wind down quantitative easing, also known as QE, by the end of 2014, the impact on short-term interest rates, and when they will start to rise, is of particular concern.

David Lloyd, head of institutional fixed income portfolio management at M&G Investments, said: “The US economy grew by 3.2% in the final quarter of 2013, yet QE is injecting $65 billion of bond purchases a month. It makes no sense to have such a stimulative policy when growth is that robust.”

Chris Iggo, chief investment officer of fixed income at Axa Investment Managers, believes a normal macroeconomic environment, where both government bond yields and short-term interest rates are closer to historic averages, will eventually prevail but the voyage will be choppy. He said: “The transition will cause volatility and re-pricing of assets. And the journey will not be a linear one as it’s impossible to forecast when interest rates will rise and how economies will respond.”

Asset managers warn that pension schemes should recognise the impact of tapering not only on government bonds but all financial assets.

Longer term, investors will be better off because a more normal financial market environment should prevail resulting in higher yields, according to Iggo.

Minimising impact

But even though pension schemes are long-term investors, their assets are regularly marked to market so they will be affected by market volatility and should take the necessary steps to minimise the impact.
Some advisers recommend taking an approach that targets volatility. Datta said: “We advise pension schemes to invest in a more defensive manner, for example investing in a minimum-volatility strategy.”

Allocating more risk assets to alternative strategies such as long/short hedge funds or global macro could be a better option as they have the flexibility to do well in both rising and falling markets, according to Datta.

Pension schemes could also buy equity market volatility protection. These are typically a mix of derivative instruments that pay when markets either fall or become volatile, according to Datta. He said: “These instruments, however, are not cheap and the cost of maintaining them can result in a drag on performance.”
It’s not only equities that will be affected by the reduction in QE – fixed income assets such as high-yield bonds will feel the pinch too. While there’s no reason to think there could be a dramatic decrease in the credit quality of these instruments, it still might be a good time to exit these asset classes, according to Iggo. He said: “High yield has become very crowded with rich valuations and very tight spreads.”

--This article first appeared in the print edition of Financial News dated March 10, 2014